Sector Spotlight: Consumer Discretionary Spending & Outlook

Consumers wined, dined, and bought lots of new cars last year, fueling the consumer discretionary stock sector to double-digit gains in a not-so-glamorous run of stock market trading. But will the sector, with all its fun and frolic, still have steam in 2016? The answer lies in the hands of the predictably unpredictable consumer.

If 2015’s consumer sector results are any indication, consumers emboldened by better job prospects and low gasoline prices will continue to spend more freely on material things that make them happy and keep them technologically fashionable and up to date.

In a year when financial markets dipped into the red in the final hours of trading, consumer discretionary shone. The Consumer Discretionary Index handily outpaced the nine other sectors of the S&P 500—posting a roughly 9% gain in 2015, according to S&P Capital IQ data.

Early Birds

Consumer discretionary stocks are considered "cyclical" stocks, or those that tend to wax and wane with expectations for economic growth. These differ from defensive sectors, which include stocks of must-have items like food, health care, and utilities—things consumers generally can't do without no matter what’s going on in the economy or with its outlook. The three biggest categories within the consumer discretionary sector are Internet retail, movies/entertainment, and restaurants, says Sam Stovall, managing director at S&P Capital IQ.

Historically, consumer discretionary stocks are early-cycle performers, gaining in a low or falling interest rate environment because they are credit-sensitive sectors of the economy. Wall Street's current expectation for a slow and measured pace of interest rate hikes in 2016 is not expected to derail the consumer discretionary sector—at least not right now. Many stock experts looking into the crystal ball for 2016 see continued strength in consumer discretionary stocks. But, as always, risks hang on the horizon as well.

Bullish Case

Stovall outlines the potential positives for consumer discretionary stocks in 2016:

• Strong earnings growth. "We believe consumer discretionary should outperform in the market. Earnings growth will be nearly twice [that of the index] at plus 14.8% for consumer discretionary in 2016 versus earnings at 8% for the S&P 500."
• Interest rate hikes by the Federal Reserve should be slow and measured. "Even though the Fed is expected to raise rates to between 1.25% and 1.50% by the end of 2016, that interest rate level is still stimulative, in our opinion, because it will be below the rate of inflation."
• Consumer discretionary stocks have a lower exposure to foreign exchange risk. Many consumer discretionary companies are rooted in domestic sales, which protects revenues from the impact of a rising U.S. dollar. "Consumer discretionary stocks have a lower exposure to international markets than the S&P 500 as a whole, and should be less adversely affected by a strengthening dollar in 2016."

Bearish Case

Of course, for every yin there is a yang, and Stovall warns of sector risks:

• If consumers focus on improving their personal balance sheets and continue to pay down debt, it could lead to less discretionary spending.
• Oil prices are low now, funneling extra dollars into consumers' pockets. A sustained move higher in oil and gasoline prices could crimp discretionary spending.
• The Fed is a wild card. If it hikes rates more quickly than it has signaled, it could dampen positive momentum in the sector. On the other hand, if it doesn’t follow its prescribed course, that could indicate economic uncertainty.